For those concerned with the plight of the global economy, there is good cause to worry and wonder about what is happening in Japan. First, the good news. Corporate bankruptcies there rose over 23 percent to 19,071 during 2000. Although the number in not the highest annual tally, the uncovered liabilities left over by bankrupt firms rose by 77 percent to almost 24 trillion and are now said to be at a postwar high.
Included in the toll were life insurers, non-bank financial firms and distribution companies, at least 12 of which were listed companies. Several retailers like Nagasakiya Co and Sogo Co fell victim as did the non-bank financial firms Nichiboshin Ltd and Life Co. As difficult as these adjustments may be, the economy would be much worse off if they had not happened.
ILLUSTRATION: MOUNTAIN PEOPLE
Now the bad news. Japan's stillborn recovery is evident in the downward revisions of industrial output growth on the back of stalling export growth. With consumer spending remaining slack, there are fears of an intensified deflationary spiral whereby price declines and recessions occur in a self-reinforcing cycle.
First there were signs that the economy tanked during the fourth quarter of the past year. And then, recent evidence in the price indices confirm that Japan is likely to be back on a downward trend. The consumer price index in Tokyo for non-perishables dropped about 0.7 percent in 2000. This was the largest year-on-year decline on record. And the national consumer price index has recorded year-on-year declines for over 15 consecutive months. After a peak in April, the domestic wholesale price index began falling again with a year-on-year decline recorded in October.
Not all of this is a bad sign. Some of these price declines are the result of technological progress and price-cutting among companies that is part of a healthy process of liquidation of excess inventories. According to the Economic Planning Agency, lower production costs combined with price declines resulting from the effect of streamlining distribution systems explain much of the decline in the consumer price index. Housing rent has also decreased and pushed the price index down as home ownership has risen due to low interest rates and large tax cuts affecting new housing loans.
In considering the viability of policy responses to these woeful conditions, it should be understood that increasing monetary liquidity would not halt the increased volatility in Japan's financial markets nor end the deflationary pressures. As it is, the BOJ has already set the unsecured overnight call rate at 0.25 percent.
During the years of the "bubble economy," there was an over-expansion of capital goods inspired by cheap credit but unsupported by changes in real demand. What Japan needs to experience is the liquidation of its excess capacity, not to promote inflation as a way to try to force people to spend their money before it loses its value.
When central banks artificially lower interest rates, it leads to a diversion of funding away from wealth producers towards wealth consumers. This is because interest rates help coordinate the plans of consumers and producers. One of the most important determinants of interest rates is the reaction of consumers in exercising their preferences concerning choices between present and future consumption. In this sense, interest payments are the compensation for deferred consumption. At the same time, interest rates guide businesses towards the most profitable allocation of funding as indicated by consumer choices.
When a monetary expansion occurs and interest rates are lowered artificially, they no longer mirror consumers' preferences. Consequently, business decisions that are made on the basis of the lowered interest rates will be in error. These errors are unavoidable as long as monetary policy remains expansionary, inducing entrepreneurs to commit themselves to business ventures that eventually prove to yield an unsustainable profit rates. As such, profits become inflated and support an artificial sense of prosperity that encourages the diversion of funds from wealth-generating activities toward non-wealth generating activities.
As the boom nears its peak, industries that produce capital goods begin to suffer from a squeeze in profits as prices of inputs rise faster than the prices of their outputs. Eventually, costs continue to rise even as the demand for output falls. In the end, excess capacity becomes apparent and workers will have to be laid off. In fact, this is what lay behind the "bubble economy" that is the source of the current problems.
And so it is that slackening consumer demand is an effect, not a cause of an economic downturn. Likewise, a sustainable recovery depends upon increased spending on capital goods in response to real changes in the economy. Only when new jobs are created can there be an increase in real purchasing power.
It is a misguided notion that Japan's economic malaise is due to deficient consumer spending and can be fixed by inflating the money supply. Even economists who should know better believe that consumer spending is the principal villain behind Japan's apparently endless slump. This misconception is probably based upon the fact that consumption expenditures account for nearly two-thirds of the GDP of most industrialized economies.
However, GDP does not reflect gross expenditure. This is because GDP does not record spending on intermediate goods that flow from one stage of production to another. When these expenditures are included, consumer spending as a proportion of national income drops precipitously. Any joy about rising retail sales figures (or gloom from declining retail sales) only masks the grim realities of excess capacity.
Instead of focusing upon consumption of durable goods, there should be greater interest in what is happening in the capital goods industries. For it is the lack of demand for capital goods that is the clearest harbinger of the health of the economy.
The depth and duration of a recession depends upon the extensiveness of a monetary expansion and the length of time interest rates remain artificially low. In the end, these determine the amount of misallocated capital that will have to be released to more productive uses. Unfortunately, Japan has resolved only a small fraction of the necessary liquidations of poorly invested capital. The appropriate way to move Japan's economy forward is: Liquidate, do not inflate.
Christopher Lingle is Global Strategist for eConoLytics.com
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